Analysis: Bankruptcy filing may be bad option for Detroit

By Tom Hals

Published February 21, 2013

Reuters

WILMINGTON, Delaware (Reuters) - If the city of Detroit were a company, it would be a prime candidate to file for bankruptcy, using court protection to cut debt, streamline operations and trim retiree benefits.

But what may be good for General Motors may not be good for the home of the U.S. auto industry.

A state-appointed panel of experts on Tuesday declared Detroit in financial crisis, and Michigan Governor Rick Snyder is widely expected to soon appoint an emergency financial manager to take over many of the city's functions.

Detroit Mayor Dave Bing and the City Council oppose a state takeover in part because they would lose much of their power to the emergency manager. And bankruptcy is the last thing they want.

While that emergency manager could recommend putting the city into a Chapter 9 bankruptcy, which is reserved for cities, few experts expect that to happen.

"This is too critical and it is too important to the state to be left to the dynamic uncertainty of a Chapter 9 process," said James Spiotto, an attorney with Chapman and Cutler in Chicago and one of the leading experts on municipal bankruptcy. "Chapter 9 is time-consuming, uncertain, expensive and unpredictable."

Not only could it be messy for Detroit, but also for other Michigan cities whose credit worthiness might be questioned, experts said. Instead of stanching the bleeding, it might spread it.

General Motors Corp, which has its headquarters in downtown Detroit, filed for Chapter 11 bankruptcy in 2009. It received a bailout of $49.5 billion from the U.S. government that was converted to an ownership stake once GM emerged from bankruptcy.

Detroit's problems, including $14 billion in long-term liabilities, cry out for a radical fix. But few expect the federal government to come to the city's aid.

Its population has plummeted to 700,000 from 1.8 million and the departing residents took with them the city's tax base. They left behind a glut of foreclosed homes, high crime and a city struggling to provide basic services and meet pension obligations.

Once a new state law takes effect on March 28, Detroit's emergency manager would have sweeping powers to restructure the city. Among those powers would be the ability to replace current union agreements with ones that are more affordable for the city, said Eric Scorsone, who specializes public finance at Michigan State University.

Labor costs account for 49.5 percent of Detroit's operating budget, in the fiscal year ending June 30.

Spiotto said the emergency manager has the ability to focus on problems with precision, while the Chapter 9 process is more scattered.

"Bankruptcy for the most part is a shotgun blast," said Spiotto. That disrupts all of a city's relationships, from its suppliers to lenders to labor, not just those at the center of its crisis.

If it filed, Detroit would be the largest municipal bankruptcy in history, surpassing Jefferson County, home to Alabama's largest city, Birmingham, which filed for bankruptcy in 2011 with $4.23 billion in debt.

It would also be the first time since at least 1950 that the largest city in a state filed for bankruptcy, said Spiotto. Michigan state officials would have the power to block a bankruptcy filing.

Others have come to the brink of insolvency like New York City in 1975 and Philadelphia in 1991. Both were able to put their finances in order after state governments intervened.

States have been motivated to deal with local governments in distress by the fear that a bankruptcy could taint other struggling municipalities, worsening the problem.

"That's the theory. That if Detroit goes under, then Flint will have to pay more and Lansing is going to have pay more and Grand Rapids and even cities in other states," said Scorsone, referring to a ripple effect of investors demanding higher interest rates on bonds issued other metro areas.

The experience of cities that have gone bankrupt hardly encourages its use. The California city of Vallejo emerged from bankruptcy in 2011 with less burdensome union contracts and debt, but crime has soared, businesses have fled and property values have plunged.

For now, Scorsone said he thought there was a low probability of Detroit filing for bankruptcy, and many experts following the situation generally seemed to agree.

But if progress isn't made in the next six months, that optimism could fade.

There are lingering questions about the legality of the emergency manager and the authority to alter contracts.

"Everything the person does that is controversial will be challenged in court," said Scott Eisenberg at Amherst Partners, and a past president of the Detroit Chapter of the Turnaround Management Association.

If those legal challenges bog down the emergency manager, bankruptcy may become inevitable.

Scorsone said events playing out in Flint, a Michigan city about 70 miles northwest of Detroit, might foreshadow what lies ahead.

An emergency manager was appointed and the city's problems improved from "off-the-charts bad", but some changes have been reversed in court, raising the prospect of bankruptcy, said Scorsone.

"If it doesn't work in Flint, it probably won't work in Detroit," said Scorsone.

(Editing by Greg McCune, Mary Milliken and Leslie Gevirtz)

If the city of Detroit were a company, it would be a prime candidate to file for bankruptcy, using court protection to cut debt, streamline operations and trim retiree benefits.

But what may be good for General Motors may not be good for the home of the U.S. auto industry.

A state-appointed panel of experts on Tuesday declared Detroit in financial crisis, and Michigan Governor Rick Snyder is widely expected to soon appoint an emergency financial manager to take over many of the city's functions.

Detroit Mayor Dave Bing and the City Council oppose a state takeover in part because they would lose much of their power to the emergency manager. And bankruptcy is the last thing they want.

While that emergency manager could recommend putting the city into a Chapter 9 bankruptcy, which is reserved for cities, few experts expect that to happen.

"This is too critical and it is too important to the state to be left to the dynamic uncertainty of a Chapter 9 process," said James Spiotto, an attorney with Chapman and Cutler in Chicago and one of the leading experts on municipal bankruptcy. "Chapter 9 is time-consuming, uncertain, expensive and unpredictable."

Not only could it be messy for Detroit, but also for other Michigan cities whose credit worthiness might be questioned, experts said. Instead of stanching the bleeding, it might spread it.

General Motors Corp, which has its headquarters in downtown Detroit, filed for Chapter 11 bankruptcy in 2009. It received a bailout of $49.5 billion from the U.S. government that was converted to an ownership stake once GM emerged from bankruptcy.

Detroit's problems, including $14 billion in long-term liabilities, cry out for a radical fix. But few expect the federal government to come to the city's aid.

Its population has plummeted to 700,000 from 1.8 million and the departing residents took with them the city's tax base. They left behind a glut of foreclosed homes, high crime and a city struggling to provide basic services and meet pension obligations.

Once a new state law takes effect on March 28, Detroit's emergency manager would have sweeping powers to restructure the city. Among those powers would be the ability to replace current union agreements with ones that are more affordable for the city, said Eric Scorsone, who specializes public finance at Michigan State University.

Labor costs account for 49.5 percent of Detroit's operating budget, in the fiscal year ending June 30.

Spiotto said the emergency manager has the ability to focus on problems with precision, while the Chapter 9 process is more scattered.

"Bankruptcy for the most part is a shotgun blast," said Spiotto. That disrupts all of a city's relationships, from its suppliers to lenders to labor, not just those at the center of its crisis.

If it filed, Detroit would be the largest municipal bankruptcy in history, surpassing Jefferson County, home to Alabama's largest city, Birmingham, which filed for bankruptcy in 2011 with $4.23 billion in debt.

It would also be the first time since at least 1950 that the largest city in a state filed for bankruptcy, said Spiotto. Michigan state officials would have the power to block a bankruptcy filing.

Others have come to the brink of insolvency like New York City in 1975 and Philadelphia in 1991. Both were able to put their finances in order after state governments intervened.

States have been motivated to deal with local governments in distress by the fear that a bankruptcy could taint other struggling municipalities, worsening the problem.

"That's the theory. That if Detroit goes under, then Flint will have to pay more and Lansing is going to have pay more and Grand Rapids and even cities in other states," said Scorsone, referring to a ripple effect of investors demanding higher interest rates on bonds issued other metro areas.

The experience of cities that have gone bankrupt hardly encourages its use. The California city of Vallejo emerged from bankruptcy in 2011 with less burdensome union contracts and debt, but crime has soared, businesses have fled and property values have plunged.

For now, Scorsone said he thought there was a low probability of Detroit filing for bankruptcy, and many experts following the situation generally seemed to agree.

But if progress isn't made in the next six months, that optimism could fade.

There are lingering questions about the legality of the emergency manager and the authority to alter contracts.

"Everything the person does that is controversial will be challenged in court," said Scott Eisenberg at Amherst Partners, and a past president of the Detroit Chapter of the Turnaround Management Association.

If those legal challenges bog down the emergency manager, bankruptcy may become inevitable.

Scorsone said events playing out in Flint, a Michigan city about 70 miles northwest of Detroit, might foreshadow what lies ahead.

An emergency manager was appointed and the city's problems improved from "off-the-charts bad", but some changes have been reversed in court, raising the prospect of bankruptcy, said Scorsone.

"If it doesn't work in Flint, it probably won't work in Detroit," said Scorsone.